Historically, muni bond yields have tended to range between 85% and 90% of US Treasuries though the effective yield to investors has been higher because of the benefit from the tax exemption. This is because muni bond interest is tax exempt on the federal level and on the state level if you are a resident from where the bond is issued.
On the whole, investors in this asset class tend to be individuals who can be highly influenced by market conditions or comments (remember the market scare created by comments about widespread defaults that never materialized).
Current and prospective investors should not be expecting any bump in appreciation because of the likely increase in income taxes. This expectation has already been factored in as reflected in the appreciation of the popular iShares S&P AMT-Free Muni Bond (ticker: MUB) exchange traded fund since its 2012 low point around April.
So while there are opportunities in munis now, don’t think of this as a place for a quick buck.
Dos and Don’ts for Munis Now
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Don’t simply create an evenly laddered muni portfolio with bonds coming due in regular intervals.
Investors can benefit by avoiding very short-term issues (within three years) since these yields are well below the rate of inflation which will erode wealth and purchasing power.
Do buy intermediate maturities where investors can benefit from pricing and yield anomalies. Most investors will create portfolios with bonds that have five or 10-year maturities. As a result, this creates a “demand bubble” for 10-year bonds, for example, that leads to higher prices and lower corresponding yields.
A better strategy is to add a 12-year, AAA-rated bond instead of the 10-year option. Such bonds are yielding 2.2% per year versus 1.48% for a nine-year bond (before the tax-equivalent yield calculation) . There is negligible risk for adding a couple of years to the maturity of some bonds in the portfolio and there is the potential benefit for prices to increase for the 12-year bonds as the bonds mature over time.
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Do add bonds with slightly lower credit ratings.
Perfection comes with a price and for munis this results in lower yields from the greater demand for the highest rated offerings. Defaults by muni bond issuers are still rare despite the strains on municipal and state finances during the Great Recession.
Consider adding A-rated bonds. These offer a good value compared to the risk trade-off from a slightly lower credit rating. If history is any guide, A-rated munis compared to A-rated corporates have had an overall lower default rate over multiple 10-year periods from 1970 through 2011: 0.04% for munis versus 2.22% for corporates according to Moody’s.
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Don’t limit yourself to home state bonds.
While there is the added tax benefit for holding issues from your home state (no state income tax), consider the risks.
What you may give up on from a state income tax exemption by buying bonds issued by municipalities in other states you will gain in diversification.
Although the default risks have been low overall for muni issues, that doesn’t mean you should ignore the benefits from diversification. Buying issues from other states means that you minimize exposure to the politics of government finances here in Massachusetts. And given the likelihood of super storms like Sandy becoming the norm in the Northeast, you can minimize your exposure to the interruptions to municipal operations and tax collections that may result from such storms.
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Do shop for out-of-state bonds from states that have no income taxes.
States like Florida, Texas, Nevada, Washington and New Hampshire which have no state income taxes lack strong demand for their municipal issues. Take advantage of demand and supply here as well. Yields from issuers in these states tend to be richer because of this relatively weaker local demand from in state residents.
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Do keep your fees low.
As I have noted in other blogs, the one thing you can control in investing is how much you pay in investment fees. (The other thing you can control is your emotions – which is why I recommend adopting an Investment Policy Statement to help manage the investment selection and allocation process).
Index funds may not always be the best bet for muni bond holdings since the bonds held here tend to be the kinds of issues that are always high in demand – which in turn tamps down the yield. Here, an active mutual fund manager may add value since they have the flexibility to add higher-yielding issues from less popular sources.
So while a good core holding may continue to be iShares S&P AMT-Free Muni Bond (MUB), the exchange-traded fund, another option for the actively managed side would be Fidelity Tax-Free Bond (FTABX). Both are highly rated and expenses and have the same expense ratio of 0.25% of assets but the mutual fund has a slightly higher yield.
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Do consider the potential benefit of Closed End Funds.
Such funds tend to offer investors a better way to manage tax liabilities that may result from holding mutual funds. And those that can be purchased at a discount (typically those available for trade in the secondary market) offer the potential for price appreciation. You can add to a portfolio’s overall diversification and appreciation potential by rotating out of mutual funds and picking up well-priced closed-end funds.
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Do seek professional help when choosing individual bonds.
Muni issuers are as rational as any other investor. As interest rates have fallen and continue to stay low, they refinance their issues to lower their borrowing costs. While good for municipal finances, it is not good for your cash flow or the income stream you may have been counting on. So there’s always the risk of having a bond “called away” leaving the investor with cash to invest but with lower current interest rate opportunities.
There may be opportunities in higher-yielding issues available but be prepared to pay a premium price for these.
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